Don't Bank On It...

Don't Bank On It...

What bank tightening in the construction financing market means for developers.

Over the last few years, the flow of commercial construction loans has slowed as bank lenders – traditionally the primary source of construction capital – have taken a step back to comply with recent regulations and protect against a potentially overheated market.

Aside from banks, lenders of all types are tightening their lending practices, as an increasing amount of apartment inventory is hitting the market, correlating with a climbing vacancy rate. Many lenders are looking at their current construction loan portfolio and see they are not performing as expected, with pro-forma estimates being missed.

However, while banks may be pulling back, most are not pulling out. Financing alternatives from life companies, private equity debt funds and HUD, among others, are also stepping in to meet demand. Strong projects in good markets can still obtain funding.

Bank Pullback

Even with tightening lending standards, banks are still the largest player in the apartment construction market, albeit at lower leverage and higher interest rates.

Until recently, construction loans from national and major regional banks covered up to 75% of development costs for 200 to 250 basis points over LIBOR. Today, borrowers are seeing up to 65% of development costs starting at 250 basis points over LIBOR.

Putting market concerns aside, banks are also being constrained from a regulatory standpoint, as rules stemming from Basel III and Dodd Frank are requiring banks to keep more cash in reserves to offset risky investments like real estate construction loans.

Alternative Sources

Smaller, local banks, as well as non-bank lenders, are starting to pick up some of the slack now that larger banks have pulled back. Non-bank lenders operate outside the tightly regulated environment of traditional banks, allowing them to assume greater risk in exchange for a higher return for their investors.

Yes, these alternative financing sources do come at a price. The cost of capital may be twice the interest charged by a bank lender for a loan covering up to 75% of the cost of construction, with floating interest rates from 600-700 basis points over LIBOR. Although costlier, borrows are often able to access the funds more quickly. Importantly, these loans are often nonrecourse in nature.

Private equity can provide a boost to the capital stack with mezzanine financing, which, when paired with a lower leverage bank loan, can cover up to 85% of development costs for 12-13% in rate.

Life companies are another option, offering construction-to-permanent loans for top-shelf projects and top-shelf sponsors. Leverage typically tops out around 60% LTC, with fixed rates in the 4.50% to 5.00% range.

Lastly, HUD’s 221d4 construction-to-permanent execution offers up to 85% LTC for market-rate projects. However, the cumbersome nature of this execution, coupled with a funding timeline of 12 months or longer, deters many developers from going in this direction.----Do you have an upcoming construction project that requires financing? Have questions about your options? We can help. Reach out to either Brendan or Mark for information today!